1. Market Failure Market failure refers to reasons why even a perfectly
competitive market economic system might fail to provide
for an efficient allocation of resources.
The three major reasons are:
(1) Externalities
(2) Public Goods
(3) Asymmetric Information

2. EXTERNALITIES Externalities
Costs or benefits arising out of production or consumption that accrue to others in the community rather than the individual producer or consumer.

3. Externalities Negative Positive
Action by one party imposes a cost on another party
Positive
Action by one party benefits another party

4. EXTERNALITIES  Ways of Correcting Externalities
Command and Control Policies
Externalities and Property Rights

5. External Cost Scenario Steel plant dumping waste in a river
The entire steel market effluent can be reduced by lowering output (fixed proportions production function)

6. External Cost Scenario
Marginal External Cost (MEC) is the cost imposed on fishermen downstream for each level of production.
Marginal Social Cost (MSC) is MC plus MEC.

7. ExternalCosts P1 q1 Q1 MSC MSCI MEC MECI q* P* Q* MPC S = MPCI D P1
When there are negative
externalities, the marginal
social cost MSC is higher
than the marginal cost.
MEC
MECI
The differences is
the marginal external
cost MEC. q* P* Q*
The industry competitive
output is Q1 while the efficient
level is Q*.
The profit maximizing firm
produces at q1 while the
efficient output level is q*.
Price
Price
MPC
S = MPCI D P1
Aggregate
social cost of
negative
externality
Firm output
Industry output

8. External Costs The Marginal External Cost curve(MEC), is drawn upward
sloping on the assumption that as output increases, and
therefore additional effluent is dumped,the additional harm
to the fishing industry increases.
This assumption explains the increasing gap between the
Marginal (Private)Cost Curve and the Marginal Social Cost
Curve(MSC), as output increases.

9. External Cost
Negative Externalities encourage inefficient firms to remain in the industry and create excessive production in the long run.

10. Externalities Positive Externalities and Inefficiency
Externalities can also result in too little production, as can be shown in an example of home repair and landscaping.

11. External Benefits Value MSB D=MPB P1 MC P* MEB Repair Level q* q1
When there are positive
externalities (the benefits
of repairs to neighbors),
marginal social benefits
MSB are higher than
marginal benefits D. q* P*
A self-interested home owner
invests q1 in repairs. The
efficient level of repairs
q* is higher. The higher price
P1 discourages repair.
D=MPB MC P1 q1
Is research and development
discouraged by positive
externalities?
Repair Level

12. External Benefits
The Marginal External Benefit Curve (MEB) is shown here
as downward sloping as the marginal external benefit is
large fora small amount of repair, but falls as the quantity
of repair work increases - this is an assumption.
The assumption explains why the gap between the Demand
curve and the Marginal Social Benefit Curve(MSB) narrows
as the amount of repair level increases.

13. Ways of Correcting Market Failure
Assumption: The market failure is pollution
Fixed-proportion production technology
Must reduce output to reduce emissions
Use an output tax to reduce output
Input substitution possible by altering technology

14. The Efficient Level of Emissions
Assume:
1) Competitive market
2) Output and emissions decisions are independent
3) Profit maximizing output chosen
Dollars
per unit
of Emissions
MSC
MCA
At E0 the marginal
cost of abating emissions
is greater than the
marginal social cost. E0 E*
The efficient level of
emissions is 12 (E*) where
MCA = MSC. 6
Why is this more efficient
than zero emissions? 4
At E1 the marginal
social cost is greater
than the marginal cost of abatement. E1 2 2 4 6 8 10 12 14 16 18 20 22 24 26
Level of Emissions

15. The Efficient Level of Emissions
The MCA curve is the Marginal Cost of Abating Emissions.
In this example, it measures the additional cost to the firm of
installing pollution control equipment.
The curve has been drawn downward sloping from left to
right, on the assumption that the marginal cost of reducing
emissions is low when the reduction in emissions has been
small, but high when it has been large.
Eg. A small reduction inexpensive - reschedule production
to have largest emissions at night when few people around.
Relatively cheap.

16. Ways of Correcting Market Failure
Options for Reducing Emissions to E*
Emission Standard
Set a legal limit on emissions at E* (12)
Enforced by monetary and criminal penalties
Increases the cost of production and the threshold price to enter the industry

17. Standards and Fees MSC 3 MCA E* 12 Standard Fee Dollars per unit
of Emissions
MSC
MCA 3 12 E*
Standard
Fee
Level of Emissions

18. Ways of Correcting Market Failure
Options for Reducing Emissions to E*
Emissions Fee
Charge levied on each unit of emission

19. Standards and Fees MSC 3 MCA E* 12 Cost is less than the
Dollars
per unit
of Emissions
MSC
MCA
Total
Abatement Cost
Cost is less than the
fee if emissions were
not reduced. 3 12 E*
Fee
Total Fee
of Abatement
Level of Emissions

20. Ways of Correcting Market Failure
Standards Versus Fees
Assumptions
Policymakers have incomplete information
Administrative costs require the same fee or standard for all firms

21. The Case for Fees MCA1 MCA2 3.75 2.50 Fee per Unit of Emissions 6 5 4
The impact of a standard of
abatement of 7 for both firms
is illustrated.
Not efficient because
MCA2 < MCA1.
Fee per
Unit of
Emissions
MCA1
MCA2
If a fee of $3 was imposed
Firm 1 emissions would fall
From 14 to 8. Firm 2 emissions
would fall from 14 to 6.
MCA1 = MCA2: efficient solution. 6
The cost minimizing solution
would be an abatement of 6
for firm 1 and 8 for firm 2 and
MCA1= MCA2 = $3. 5 4
Firm 2’s Reduced
Abatement
Costs
Firm 1’s Increased
Abatement Costs 3 2 1
Level of
Emissions 1 2 3 4 5 6 7 8 9 10 11 12 13 14

22. The Case for Fees
Assume two firms with the same marginal social cost of
emissions but different marginal cost of abatement as
reflected in different MCA curves.
As in the previous diagram,efficiency requires that total
emissions be reduced by 14 units to 12.
The cheapest way is to have Firm 1 reduce by 6 and
Firm 2 by 8. In this case both firms would have MCA of
$3, and the result would be achieved with a fee of $3.

23. The Case for Fees
But a standard set common for both firms at 7units, while
resulting in a 14 unit reduction,will not be cost-minimizing
since the MCA of each firm will be different - $3.75 for Firm 1
and $2.50 for Firm 2.
This cannot be cost -minimizing since Firm 2 can reduce
emissions more cheaply than Firm 1.

24. Ways of Correcting Market Failure
Advantages of Fees
When equal standards must be used, fees achieve the same emission abatement at lower cost.
Fees create an incentive to install equipment that would reduce emissions further.

25. information standard is 9
The Case for Standards B C
Based on incomplete
information fee is $7
(12.5% reduction).
Emission increases to 11.
Marginal
Social
Cost
Marginal Cost
of Abatement
Fee per
Unit of
Emissions
ABC is the increase
in social cost less the
decrease in abatement
cost. 16 14 12 E
Based on incomplete
information standard is 9
(12.5% decrease).
ADE < ABC D 10 A 8 6 4 2 2 4 6 8 10 12 14 16
Level of Emissions

26. The Case for Standards
If MSC is steep (inelastic), and MCA is relatively flat(elastic)
The efficient emissions fee is $8 - see diagram. But what
if due to inadequate information, a fee of $7 is charged.
Because MCA is elastic, emissions will be increased a lot
(not reduced as much) compared with correct fee of $8.
Also, because MSC is inelastic, there are significant increases
in social costs.

27. The Case for Standards
Compare the social loss - the increase in social costs less
the increase in abatement costs(ACD), with the loss if a
similar error were made in setting a standard - at say 9 units
instead of 8. Now the loss is the smaller triangle AED.

28. Ways of Correcting Market Failure
Summary: Fees vs. Standards
Standards are preferred when MSC is steep and MCA is flat.
Standards (incomplete information) yield more certainty on emission levels and less certainty on the cost of abatement.

29. Ways of Correcting Market Failure
Summary: Fees vs. Standards
Fees have certainty on cost and uncertainty on emissions.
Preferred policy depends on the nature of uncertainty and the slopes of the cost curves.

30. Ways of Correcting Market Failure
Transferable Emissions Permits
Permits help develop a competitive market for externalities.
Agency determines the level of emissions and number of permits
Permits are marketable
High cost firm will purchase permits from low cost firms

31. Transferable Emissions Permits
Under this system, firms least able to reduce emissions,
buy the permits. So assume that in the previous diagram,
each firm was given a 7 units emission permit. A market in these permits would then develop.
Firm 1 with high marginal cost of abatement would be
willing to pay up to $3.75 for a one unit permit. But Firm 2
has lower marginal cost of $2.50 so would be willing to sell
permits to Firm 1 for between $2.50 and $3.75.

32. Transferable Emissions Permits
If there are enough firms and permits, a competitive market
in permits will develop, and the equilibrium price will
tend to equal the marginal cost of abatement for all firms.
Otherwise, a firm with a higher marginal cost will find it
profitable to purchase more permits, pushing up their price.

33. Transferable Emissions Permits
This approach combines the advantageous features
of a standards approach and the cost advantage of a fee
system.
-agency fixes level of pollution, abatement and permits
appropriate.
-market in permits ensures abatement at minimum cost.

34. Externalities and Property Rights
Legal rules describing what people or firms may do with their property
For example
If residents downstream owned the river (clean water) they control upstream emissions.

35. Externalities and Property Rights
Bargaining and Economic Efficiency
Economic efficiency can be achieved without government intervention when the externality affects relatively few parties and when property rights are well specified.

36. Profits Under Alternative Emissions Choices (Daily)
Factory’s Fishermen’s Total
Profit Profit Profit
No filter, not treatment plant
Filter, no treatment plant
No filter, treatment plant
Filter, treatment plant

37. Externalities and Property Rights
Assumptions
Factory pays for the filter
Fishermen pay for the treatment plant
Efficient Solution
Buy the filter and do not build the plant

38. Bargaining with Alternative Property Rights
Right to Dump Right to Clean Water
No Cooperation
Profit of factory $500 $300
Profit of fishermen $200 $500
Cooperation
Profit of factory $550 $300
Profit of fishermen $250 $500

39. Externalities and Property Rights
Conclusion: Coase Theorem
When parties can bargain without cost and to their mutual advantage, the resulting outcome will be efficient, regardless of how the property rights are specified.

40. Externalities and Property Rights
A Legal Solution --- Suing for Damages
Fishermen have the right to clean water
Factory has two options
No filter, pay damages
Profit = $100 ($500 - $400)
Filter, no damages
Profit = $300 ($500 - $200)

41. Externalities and Property Rights
A Legal Solution --- Suing for Damages
Factory has the right to emit effluent
Fishermen have three options
Put in treatment plant
Profit = $200
Filter and pay damages
Profit = $300 ($500 - $200)
No plant, no filter
Profit = $100

42. Summary
There is an externality when a producer or a consumer affects the production or consumption activities of others in a manner that is not directly reflected in the market.
Pollution can be corrected by emission standards, emissions fees, marketable emissions permits, or by encouraging recycling.

43. Summary
Inefficiencies due to market failure may be eliminated through private bargaining among the affected parties after property rights have been allocated.